The Independent Investor

What's up with Big Pharma?

William Schmick

Posted:
04/25/2014 12:01:41 PM EDT

This week several multi-billion deals were announced in the pharmaceutical sector. Merger and acquisitions on a global scale appears to be heating up in this sector with over $140 billion in transactions so far this year. What's behind this feeding frenzy?

We all know that the majority of Baby Boomers are getting older so the demand for health care of all kinds is growing. As a result, the health care sector overall is a great place to invest. While many other industries experienced a devastating drop in profits and revenues over the last five years, the pharmaceutical industry weathered the financial crisis fairly well.

But that's the good news. The bad news is that the cost of bringing a new drug to market has skyrocketed. The development time has lengthened as well while a drug's patent expiration leaves companies open to low-cost competition. Today it is estimated that the cost of inventing and developing a new drug can be as much as $5 billion. The risk is even greater since 95% of the experimental medicines that are studied in human trials fail to be both effective and safe.

When you combine the astronomical costs involved, the lead time and a 5% chance of success, it is no wonder that pharmaceutical companies are searching for alternative ways to succeed and thrive in this kind of environment. A merger or acquisition, as opposed to years of in-house research and development, can make more economic sense.

Back in the day, big pharmaceutical companies used M&A activity to diversify.

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The concept was to be able to offer a line-up of drugs and treatments in various areas of medicine and treatment. That way, if one area did poorly, others would compensate. More categories of treatment, it was thought, would also improve the number of new drugs under development in the pipeline. The problem with that concept was that health care treatment has evolved differently over time. The trend in the industry is toward developing specialty drugs. Drug companies are thinking in terms of disease-related, treatment-specific portfolios and patient groups (such as cancer, diabetes, heart disease, etc.).

As a result, many drug companies have reversed course and are attempting to sell-off what they deem are "noncore assets." Companies are shuffling their portfolios, selling some product groups while acquiring others. These purchases involve smaller companies and subsidiaries of various global companies as the race is on to build franchises in strategic disease areas.

But M&A is not the only road to success. Collaboration and partnerships among global companies is also increasing. While all of these companies have different visions, the dramatic changes they face on all fronts from global government regulation, to Obamacare in this country to the dynamic revolution of the life sciences industry, itself, is altering the way they manage risk and focus their business. Sharing costs and expertise is another new trend in the healthcare arena. As companies understand and become familiar with their partners' core and noncore assets, deals are a natural outgrowth of this collaboration and being made with increasing regularly.

These agreements take on a new immediacy when the fast-growing emerging markets are taken into account. Regulations are usually less onerous in these developing markets, market share for new drugs is a wide open proposition and an exploding middle-class with purchasing power are an irresistible combination. Smaller local drug makers in some of these markets, like Latin America and India, have become big enough to catch the eye of U.S. and European behemoths. I expect even more M&A activity there as well.

So the M&A activity that we are seeing is a natural outgrowth of the changes that are occurring in the health care sector worldwide. Those changes are expected to continue and with it so will the pharmaceutical sector.

Bill Schmick is registered as an investment advisor representative and portfolio manager with Berkshire Money Management.

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